Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

AcF100 > Week 15 - Bonds > Flashcards

Week 15 - Bonds Flashcards

1
Q

What is the bond indenture?

A

a legal contract between a bond issuing company and bondholders

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What does the bond indenture include?

A
  • basic terms of the bonds
  • total amount of bonds issued
  • a description of the bond security, or whether the bond is secured or unsecured
  • sinking fund provisions
  • embedded options (call/ put/ convertible provisions)
  • details of protective covenants (restrictions and obligations)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What are two bond classifications?

A
  1. security
  2. seniority
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What are different types of bonds based on their security and features

A

collateral - secured by financial securities
mortgage - secured by real property, normally land or buildings
debentures - unsecured
notes - unsecured debt with original maturity less than 10 years

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What are collateralised bonds?

A

These bonds are backed by specific financial assets, such as stocks, bonds, or other securities. In case the issuer defaults, the bondholders can claim the underlying collateral.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What are mortgage bonds?

A

These bonds are secured by real estate, such as land or buildings. If the issuer defaults, bondholders can take possession of the property or land to recover their investment.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What are debentures (unsecured)?

A

These bonds are not backed by any collateral or specific assets. Instead, they are backed only by the creditworthiness of the issuer. Debentures tend to be riskier for bondholders than secured bonds.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What are notes (Unsecured Debt with Maturity Under 10 Years)?

A

Notes are short-term debt instruments, usually with a maturity of less than 10 years. Like debentures, they are unsecured, meaning they are not backed by collateral.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What is the seniority of a bond?

A

refers to the order in which bondholders are paid in case of liquidation or bankruptcy of the issuer.

The seniority determines the priority of claims on the issuer’s assets and income.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What typical seniority structure are involved in bonds?

A

Senior bonds and subordinated (Junior) bonds

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What are senior bonds?

A

These are the highest-ranking bonds in terms of repayment priority. Senior bondholders are paid first in the event of liquidation. These bonds are usually secured (backed by collateral), offering a lower risk to investors.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What are subordinated (junior) bonds?

A

These bonds are ranked lower than senior bonds and have a lower claim on the issuer’s assets in case of bankruptcy. They carry a higher risk and typically offer higher interest rates to compensate for this increased risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What does the required return from a bond depend on?

A

its risks characteristics

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What do these risk characteristics include?

(chat gpt)

A
  1. Credit risk
  2. Interest rate risk (market risk)
  3. Inflation risk
  4. Liquidity risk
  5. Time to maturity
  6. Tax considerations
  7. Issuers financial strength and stability
  8. Economic and market conditions
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

How is coupon rate linked to risk characteristics?

A

coupon rate is also a function of risk characteristics of a bond, but only when issued

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What are zero-coupon bonds?

A

their coupon rate is 0%, make no periodic interest (coupon) payments

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What are zero-coupon bonds also called?

A

zeroes, or deep discount bonds

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What does zero-coupon bonds entire yield to maturity come from?

A

the difference between the bonds purchase price (the price at which it is bought) and the par value (the amount paid at maturity)

since zero-coupon bonds do not make periodic interest payments, all the return to the investor is earned through this price appreciation over time

cannot sell for more than par value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

Zero coupon bond example: What is the present value of a 10 year pure discount bond paying £1,000 at maturity if the appropriate interest rate is currently 5%, 10% or 15%

A

using the formula PV = F/(1+r)^t

if interest rates are 5%, PV = £613.91
if interest rates are 10%, PV = £385.54
if interest rates are 15%, PV = £247.18

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What are floating rate bonds?

A

adjust their interest payments (coupons) at regular intervals, typically every 3 to 6 months, aligning with current market rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

When do coupon rates float?

A

coupon rate floats depending on some index value, there is less price risk with floating rate bonds

the coupon floats, so is less likely to differ substantially from the yield-to-maturity

coupons may have a ‘collar’ - the rate cannot go above a specified ‘ceiling’ or below a specified ‘floor’

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

What are semi-annual coupons?

A

a bond pays interest twice a year instead of once annually, bonds issued in the US/ UK usually do this

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What is an effective annual yield?

A

EAY, used for bonds, investments and securities with compounding returns

Represents the true annual return on an investment, considering compounding

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

What is effective annual rate (EAR)?

A

used for loans, saving accounts, credit cards and mortgages

Represents the true interest rate a borrower pays or an investor earns after compounding

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

Semi annual coupons, find the bond price and EAY (effective annual yield):
Suppose time to maturity = 7 years
Coupon rate = 14%
Face Value = £1000
Yield to maturity quoted at 16% (APR)

A

Coupon payment = 0.14 x 1000 = 140 (per annum)

1st coupon 70
2nd coupon = 70

T= 7 years -> t=14 (14 coupons in 7 years)

YTM = 16% -> semi annual rate = 8%

Bond Price = 70/0.08 (1- 1/(1+0.08)^14) + 1000/(1+0.08)^14
= 918.56

EAY = (1+ 0.16/2)^2 -1 =0.1664 = 16.64%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

What are embedded options?

A

special features built into bonds or other financial instruments that give either the issuer or investor certain rights

these options affect the bond’s price, yield and risk profile

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

What are the 3 types of embedded options?

A
  1. Callable
  2. Putable
  3. Convertible
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

What are callable bonds?

A

grants the issuers the right to retire (redeem/repay) the bond before scheduled maturity date

allows the investors to change the maturity of a bond

Eg: A company issues a 10-year bond but reserves the right to call (redeem) it after 5 years if interest rates decline.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

What are putable bonds?

A

it grants the bondholders the right to sell the bond back to the issuers at par value on designated date

allows the investors to change the maturity of a bond

Eg: An investor buys a 20-year bond but can put (sell) it back to the issuer after 10 years.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

What are convertible bonds?

A

gives the bondholders right to exchange the bond for common stock at a pre-specified price

allows the investors to take advantage of favourable movements in the stock price

Eg: A bondholder holding a $1,000 convertible bond can exchange it for 50 company shares if the stock price rises above a certain level.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

Between secured debt and debenture which would have a higher coupon rate?

A

debenture since there is no collateral there and is riskier

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

Between subordinated debenture and senior debt which would have a higher coupon rate?

A

Subordinated debt implies we are junior creditors to someone else, therefore being junior we want to demand higher coupons

Since subordinated debentures are riskier due to their lower ranking in the capital structure, investors demand a higher return (coupon rate) as compensation for taking on the additional risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

Between a bond with a sinking fund and bond without a sinking fund which would have a higher coupon rate?

A

A bond without a sinking fund would typically have a higher coupon rate compared to a bond with a sinking fund.

Investors perceive bonds with a sinking fund as less risky since there is a structured plan for repayment, making it more likely that they will receive their principal back.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

Between a callable and non- callable bond which would have a higher coupon rate?

A

A callable bond would typically have a higher coupon rate compared to a non-callable bond.

Non-callable bonds, which do not have early redemption risk, typically have lower coupon rates because investors are assured of receiving interest payments for the full term.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

Do bonds vary in taxation?

A

some bonds incur lower or no taxes than others

for example, in the US municipal bonds are exempt from most taxes

where lower tax rates apply, yields are lower as investors dont demand additional yield to be compensated for tax

comparisons of bonds must use after-tax yields

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

What are the 5 key characteristics of the bond market, specifically the secondary market for bonds

A
  1. Primarily Over-the-Counter (OTC) transactions
  2. Large number of bond issues, but low trading volume per issue
  3. Difficult to get up-to-date prices
  4. Government Bonds are an exception
  5. U.S. Treasury bond market is the largest by trading volume
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
37
Q

What are bonds mostly traded through?

A

Unlike stocks, which are often traded on exchanges, bonds are mostly traded OTC through dealers and brokers who are connected electronically

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
38
Q

Why are there large number of bond issues, but low trading volume per issue?

A

There are thousands of different bonds issued by governments, municipalities, and corporations, but each bond may not trade frequently.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
39
Q

Why is it difficult to get up-to-date prices?

A

Since most bonds trade OTC and not on centralised exchanges, pricing transparency is limited, especially for smaller company bonds or municipal bonds

40
Q

Why are government bonds an exception?

A

Government bonds (like U.S. Treasuries) are more actively traded, and their prices are easier to obtain

41
Q

Why is the US treasury bond market the largest by trading volume?

A

The U.S. Treasury market is the most liquid and largest securities market globally, with trillions of dollars in daily trading volume

42
Q

What is the clean price of a bond?

A

The quoted price of a bond, excluding accrued interest

43
Q

What is the dirty price of a bond?

A

The total amount the buyer actually pays, which includes accrued interest

44
Q

Example bond quotations and prices

A

You buy a bond with a 12% coupon paid semi-annually and you pay £1,080 (purchase price, dirty price). The next coupon is due in 4 months and will be £60 (semi-annual coupon payment)

The accrued interest paid is the fraction of time since the last coupon payment (2 months) × the next coupon (£60)

Accrued interest is therefore 2/6 × £60 = £20.

Dirty price = Clean price + Accrued interest
The clean price would be £1,060

So, the quoted price is £1,060 (clean price), but the amount paid is £1,080 (dirty price), because the buyer compensates the seller for the interest that has accrued since the last coupon payment

45
Q

Example of accrued interest: A bond has a coupon rate of 7.5%, semi-annual coupons and a clean price of £915. If the next coupon payment is due in 3 months, what is the invoice (dirty) price?

A

Coupon payments are £75 a year, so £37.50 twice a year.
Next payment is in 3 months, so accrued interest is 37.50/2 = 18.75
Invoice price is £915 + £18.75 = £933.75

46
Q

What is the bid price?

A

The price a dealer is willing to pay to buy the bond from an investor

47
Q

What is the ask price (offer price)?

A

The price at which the dealer is willing to sell the bond (this is higher than the bid price)

48
Q

What is the bid-ask spread?

A

The difference between the ask price and the bid price—this represents the dealer’s profit margin

49
Q

What is the ask yield?

A

The yield to maturity (YTM) based on the higher ask price (since you’re paying more for the bond, yield is lower)

50
Q

What is the bid yield?

A

The YTM based on the lower bid price (since you’re buying at a lower price, yield is higher)

51
Q

What are 8 major risks associated with bond investments?

A
  1. interest rate risk (this risk is by far the major risk faced by investors in the bond market)
  2. reinvestment risk
  3. default risk
  4. call risk
  5. inflation risk
  6. exchange rate risk
  7. liquidity risk
  8. volatility risk
52
Q

What is interest rate risk also known as?

A

price risk

53
Q

Why is there an inverse relationship between bond prices and interest rates?

A

When interest rates rise, the price of existing bonds tends to fall. Conversely, when interest rates fall, the price of existing bonds tends to rise

If interest rates increase, newer bonds are issued with higher coupon rates, making the existing bonds with lower rates less attractive. To compensate, the price of the older bonds must decrease to offer a competitive yield

54
Q

What is interest rate risk?

A

the risk that changes in interest rates will affect the market price of a bond.

It is especially relevant when holding bonds until they are sold before maturity

55
Q

What is the impact of interest rate risk?

A

If interest rates rise after you purchase a bond, you may be forced to sell the bond at a lower price, resulting in a capital loss

56
Q

What are 2 factors that influence interest rate risk?

A
  1. time to maturity
  2. coupon rate
57
Q

How does time to maturity influence interest rate risk?

A

The longer the time to maturity, the greater the interest rate risk

Bonds with longer maturities are more sensitive to interest rate changes because they lock in the coupon rate for a longer period

58
Q

Example of time to maturity influencing interest rate risk

A

A bond with 10 years to maturity is much more affected by a 1% change in interest rates than a bond with just 2 years to maturity. This is because there are more years of fixed payments that could become less valuable if interest rates rise

59
Q

How does coupon rate influence interest rate risk?

A

The lower the coupon rate, the greater the interest rate risk

A bond with a low coupon rate is more sensitive to interest rate changes because its payments are smaller. Most of the bond’s value is derived from its face value (principal) that is repaid at maturity. If interest rates rise, the smaller coupon payments mean the bond will lose value more rapidly compared to a high-coupon bond, where the majority of the value is in the periodic coupon payments

60
Q

Example of coupon rate influencing interest rate risk

A

A bond with a 4% coupon rate will be more affected by a rise in interest rates than a bond with a 6% coupon rate, as the higher coupon bond’s payments provide more value in the short term

61
Q

How sensitive is the bond the longer the maturity of the bond?

A

more price sensitive the bond is to
interest rate changes

62
Q

What is the intuition behind interest rate risk and coupon rates?

A

a bond with a higher coupon has a larger cash flow earlier in its life, so its value is less
sensitive to changes in discount rates

63
Q

Why do lower coupon bonds have higher interest rate risk?

A

A bond with a lower coupon has more of its value tied to the final principal payment, making its price more affected by changes in the discount rate (interest rate)

64
Q

What is credit risk?

A

he risk that the bond issuer fails to make interest or principal payments on time

65
Q

What is credit risk also known as?

A

default risk

66
Q

What is the calculation of the value of the bond using YTM based on?

A

the assumption that there is no possibility of default

assumes that all coupon payments and the principal will be paid in full

67
Q

What does higher credit mean for required return?

A

if there is any credit risk, investors will require a higher return

Investors demand a higher yield (risk premium) to compensate for the risk of potential default.

68
Q

What is the credit spread?

A

This extra yield over a “risk-free” bond (such as U.S. Treasuries)

69
Q

Example of credit risk

A

A U.S. Treasury bond might yield 4% (virtually no credit risk).
A corporate bond from a lower-rated company might yield 8% because investors require extra compensation for the risk of default

70
Q

What are bond ratings?

A

Bond ratings measure default risk—the likelihood that an issuer will fail to make interest or principal payments on time.

These ratings are provided by:
Moody’s Investor Service
Standard & Poor’s (S&P)
Fitch Ratings

71
Q

What are the bond rating categories?

A

Investment-grade bonds (BBB-/Baa3 and above) are considered low risk.

Junk bonds (high-yield bonds) (BB+/Ba1 and below) have higher risk but offer higher returns.

A “D” rating means the issuer has defaulted.

72
Q

What are 4 reasons why financial managers care about their firm’s bond ratings?

A
  1. lower borrowing costs
  2. access to capital
  3. market perception
  4. convenant compliance
73
Q

How do bond ratings affect borrowing costs?

A

Higher bond ratings mean lower interest rates when issuing debt, reducing financing costs

74
Q

How do bond ratings affect access to capital?

A

Investment-grade ratings allow firms to attract institutional investors (e.g., pension funds, mutual funds), which often cannot buy junk bonds

75
Q

How do bond ratings affect market perception?

A

A downgrade in credit rating can cause stock and bond prices to fall, affecting investor confidence

76
Q

How do bond ratings affect covenant compliance?

A

Some loan agreements require firms to maintain a certain credit rating

77
Q

What are nominal interest rates?

A

The stated interest rate without adjusting for inflation

78
Q

What financial rates are almost always quoted in nominal terms?

A

interest rates, discount rates and rates of
return

79
Q

What does the nominal rate represent?

A

The raw return in currency terms (£, $, €)

80
Q

What are real interest rates?

A

The inflation-adjusted interest rate, showing the true change in purchasing power

81
Q

What do real interest rates represent?

A

The actual gain in terms of what you can buy with the money

82
Q

What is the fisher effect?

A

1 + R = (1 + r) x (1 + h)
R = r + h + r x h, where r x h is small
R ≈ r + h

R is the nominal rate on investment
r is the real rate on investment
(1+h) is the percentage change in the price level of goods - inflation rate

83
Q

Example of the fisher effect: if we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?

A

R = (1 + r) × (1 + h) − 1
R = (1 + 0.1) × (1 + 0.08) − 1 = 0.188, or 18.8%
approximation: R = 10% + 8% = 18%

because the real return and expected inflation are relatively high, there is a significant difference between the actual Fisher Effect and the approximation

84
Q

What is the term structure of interest rates?

A

It shows the relationship between bond yields (interest rates) and their time to maturity, assuming all other factors (credit risk, coupon size, etc.) are constant

It helps investors understand how interest rates are expected to change over time

85
Q

What is the yield curve?

A

a graph that plots time to maturity (on the x-axis), bond yields (on the y-axis)

a graphical representation of the term structure

It reflects investor expectations about future interest rates and economic conditions.

86
Q

What does an upward-sloping (normal) yield curve mean?

A

Long-term rates > Short-term rates

Economy is expected to grow, inflation may rise

87
Q

What does a downward sloping (inverted) yield curve mean?

A

Long-term rates < Short-term rates

Possible recession, as investors expect lower future rates

88
Q

What does a flat yield curve mean?

A

Long-term rates ≈ Short-term rates

Economic uncertainty; interest rates are expected to stay stable

89
Q

Why does the yield curve matter?

A
  1. Predicts Economic Trends:
    Normal Curve → Growth, higher inflation expected
    Inverted Curve → Possible recession, as investors seek safety in long-term bonds
  2. Affects Borrowing & Lending:
    Banks lend at long-term rates and borrow at short-term rates. If the curve inverts, lending profits shrink.
  3. Guides Investment Decisions:
    Investors adjust portfolios based on expected rate changes.
90
Q

What 3 factors determines the shape of the term structure?

A

The term structure of interest rates (and the shape of the yield curve) is influenced by three key factors:
1. real rate of interest (r)
2. inflation premium (π)
3. interest rate risk premium

91
Q

What is the real rate of interest?

A

This is the pure time value of money after adjusting for inflation.

It represents the compensation investors require for deferring consumption.

Since the real rate does not change much in the short term, its effect on the yield curve is relatively stable

92
Q

What is an example of the real rate of interest?

A

If the real interest rate is 2%, and there’s no inflation or risk premium, all bond yields would be around 2%, creating a flat yield curve

93
Q

What is inflation premium?

A

Investors demand compensation for expected inflation risk over time.

If future inflation is expected to rise, long-term bond yields will be higher than short-term yields → Upward-sloping curve.

If inflation is expected to decline, long-term yields fall below short-term yields → Inverted curve

94
Q

An example of inflation premium

A

Current inflation is 2%, but expected inflation in 10 years is 4% → Investors demand higher long-term yields.

This is why inflation expectations have a strong influence on the shape of the yield curve

95
Q

What is interest rate risk premium?

A

Long-term bonds carry higher risk because their prices are more sensitive to interest rate changes.

Investors demand a higher yield for holding long-term bonds to compensate for this interest rate risk.

The longer the bond’s maturity, the greater the risk premium, but at a decreasing rate

96
Q

Example of interest rate premium

A

A 1-year bond may yield 3%, while a 10-year bond yields 5% due to the additional risk premium.

However, a 30-year bond may only yield 5.5%, as the added risk premium diminishes at longer maturities

AcF100 (13 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions